What is Liquidity in Stocks and Financial Instruments?

last updated 2018-07-08

Liquidity is your ability to buy or sell a stock on any given day at a given price. This affects your investments--and the money you can make.

In an ideal world, there's always a buyer for every seller. If you own 100
shares of Coca-Cola and it's selling for $40 per
share, you can make $4000 right now with the click of a mouse. Similarly, if Intel is selling for $24 a share, you can buy 100
shares for $2400 in a snap.

For a big and popular stock that's traded as much as Intel or Coca-Cola,
that's more or less true. You can buy or sell at or near the current trading
price. You may be off by a few cents either way, but the price of a stock is
rarely a surprise.

What is Liquidity?

Investors and financial folks have a technical term to describe the ease of
making these transactions. Liquidity is the ease with which you can
buy or sell something at your desired price.

The more liquid an asset, the easier it is to sell it for a price reflecting
its value. For example, the liquidity of money is high because you can easily
trade a dollar bill for four quarters or vice versa. A stolen Picasso or Van
Gogh painting is illiquid because it's difficult to sell something so famous
that everyone knows has been stolen. You'll have to reduce the price from the
expected value (priceless!) to account for the fact that there just aren't that
many potential buyers due to the risk.

Investors may also talk of high liquidity and low liquidity. High liquidity
describes something that's easy to turn into cash (a savings account, an
individual share of publicly traded stock from a big company). Low liquidity
describes something that's harder to buy or sell, often due to a low number of
buyers or sellers or the difficulty of getting the desired price (real estate,
a stolen Picasso, seventeen thousand tons of expiring pork bellies).

Remember this point; liquid assets can be sold without hurting their value,
while illiquid assets may have to be discounted to sell them sooner.

Every Investment Has Liquidity, But How Much?

Every investment has a measurable liquidity. Liquidity measures both the
number of buyers and sellers as well as the relative demand for the asset. An
asset may have a high demand but low liquidity if buyers and sellers disagree
on the value. Without agreeing on a price, there's no transaction. Similarly,
everyone may agree on the price of a thing, but there may be few buyers or
sellers.

Cash is the most liquid investment, and the term "liquid cash" is a
tautology. Your savings account is also highly liquid. The closer an asset is
to cash, the more liquid it is —money market liquidity is high, because
the provider of this account lets you deposit and withdraw assets in cash with
impunity. Gold and silver bullion have relatively high liquidity because
bullion is fungible (one bar is as good as any other bar) and there's high
demand for trading commodity
precious metals.

Stock liquidity varies based on multiple factors—individual stock
shares are fungible, but they might not be easy to buy or sell. Liquidity also
has a time component; how much time elapses between the seller offering the
asset and the buyer accepting? A blue chip on the Dow will have a lot of buyers and sellers and
finding a willing buyer or seller is relatively easy because there are so many
transactions happening every day. If your transaction time is too slow, you may
miss out on your price. (High frequency/day traders run this risk; value
investors often do not.)

Surprisingly, a penny stock is
rarely liquid. You might have to wait a long time between transactions. You'll
have more trouble buying at the price you want because you have to do more work
to find a seller at that price and more trouble selling at the price you want
(because you have to do more work to find a buyer. Worse yet, the illiquidity
of an infrequently traded stock suggests that buyers and sellers may not agree
on a fair price. As a consequence, any trade you make has a much greater
potential to move the price of the stock dramatically.

This is one of the worst flaws of penny stocks: prices may look great and
you may see what appear to be wonderful opportunities to profit, but there
aren't enough shares traded for you to get the prices you want. Getting into a
position may be difficult. Getting out could be even worse.

Why Does Liquidity Matter to You?

The more liquid an investment, the more likely you can buy or sell it at the
current trading price, sell it now at any price, and buy or sell as much as you
want.

If you're investing regularly, you may want to keep some of your assets in
very liquid form: cash, Treasury notes, money market accounts. This way, if you
find a really great value opportunity,
you can immediately buy it. It's frustrating to have to pass up a good
investment because you can't sell another asset to free up funds (or, worse,
take a loss on an investment just to get out of a position).

To put it more bluntly: your flexibility as a value investor depends on your
ability to take advantage of great opportunities. If a good opportunity gets in
the way of a great opportunity, you may end up kicking yourself. Don't take
this too far; a good investment you can hold onto is a good investment. Yet
also be patient and don't jump on the first investment that might be good
because you feel like you must invest everything right now.

If you're investing in smaller companies (not necessarily microcaps, but anything outside of the S&P 500, DJIA, or Russell 2000, for example),
keep in mind the trading volume of the stock. Only on special occasions
(ex-dividend dates, earnings announcements, unforeseen news) will the number of
trades exceed the average. Your ability to move in and out of a position at its
current price will be limited by the available buyers and sellers.

Liquidity is Important, but It's Not Everything

Low liquidity doesn't mean that you can't sell an investment. It
means that you have more trouble selling at the current price. The
more you discount the price, the more liquid you make the asset, generally.
Think of it this way: you want to find good stocks at great prices. The better
the price, the better the stock looks! The more buyers there can be.

High liquidity is great when selling, but liquidity isn't the only good
attribute of an asset. This just a way of measuring your ability to get in or
out of a position. These measurements aren't exact, because the market isn't
100% rational. The market moves fast enough that pinning down any exact price
may be impossible.

Even so, as a rule of thumb, measuring the trading volume of a stock over
time will hint at your ability to buy and sell that stock at your desired
price. Remember, this matters only when you trade. If you've found a great
stock you can buy and hold forever, daily trading
volume and price variance doesn't really matter. Just keep owning your great
stock!